Roth Conversion: Should You Convert Your Retirement Funds?

The more you’ve managed to save in a traditional individual retirement account (IRA) or a traditional 401(k), the more you might want to consider a Roth conversion.

Why a Roth conversion? There are a few good reasons, chief among them managing taxes and RMDs: Withdrawals from Roth accounts in retirement are entirely tax free, and there are zero required minimum distributions (RMDs) once you reach 72. Mind you, there’s no free lunch, and you’ll generally owe ordinary income taxes on the amount you convert—but the advantages may outweigh the extra taxes.

“The key is to look ahead and understand the tax hit you may take now, in exchange for a future of no RMDs, tax-free withdrawals and the other more flexible options that Roth accounts offer,” says Kimberley Foss, CFP, founder of Empyrion Wealth Management in Roseville, Calif.

How Does a Roth Conversion Work?

Roth conversions are when you move money from a traditional retirement account into a Roth account. There are a few different types of Roth conversion:

Assuming the contributions you made to a traditional retirement account were deductible—that is, taken out of your paycheck pre-tax or IRA contributions deducted from your taxes—you’ll owe income tax on every dollar you convert to a Roth account. The tax hit comes in the year you make the conversion. A big conversion in a single tax year runs the risk of bumping you into a higher tax bracket—or can have other repercussions.

“All of a sudden your higher taxable income might cause your capital gains and qualified dividend income to become taxable,” says Ben Fuchs, CFP, a financial advisor in West Hartford, Conn. “And if you’re collecting Social Security, the higher income can cause that to become taxable as well, or have more of it taxed,” he says. Higher taxable income can also push your Medicare Part B and Part D premiums higher.

There’s no requirement to convert the entire balance of a traditional retirement account to a Roth account all at once—you can do partial conversions whenever you want. It’s smart to spread multiple conversions of a large balance across multiple years to minimize the impact on your taxes and other benefits.

If you convert money from a traditional IRA that you funded with non-deductible contributions, you won’t owe tax on the entire amount converted as long as the money hasn’t made any gains. To determine your tax liability when converting a traditional IRA funded with non-deductible contributions, you must file IRS Form 8606.

Beware the Roth Conversion Five-Year Rule

You probably already know about the five-year rule: The IRS charges a 10% penalty on any money you withdraw from a converted Roth IRA within the first five years. But if you decide to pursue multiple Roth conversions over several years, you need to understand that each Roth conversion has its own five-year clock.

If you were to convert a 401(k) balance to a Roth IRA in 2021, 2022 and 2023, for example, you would have three different five-year rules to abide by.

The clock for the five-year rule starts on January 1 of the year you make the conversion. So if you were to convert money in December of 2021, the IRS considers your five-year clock to have started on January 1, 2021. For that December conversion, you’d essentially have just four years left when you shouldn’t touch the money.

Advantages of Roth Conversion

  • Tax-free growth and withdrawals. Once the conversion tax is paid, there will be no further tax due on money inside a Roth account while it compounds, and no tax when you make withdrawals (after clearing the five-year rule.)
  • Minimize Your RMDs. Roth IRAs are totally free of any required minimum distributions. Remember, even Roth 401(k)s have RMDs. And even if you only convert some of your traditional account balances, the smaller balances left in traditional accounts mean smaller annual RMDs when you turn 72.
  • Hedge against rising tax rates. Individual tax rates are near historic lows, and the federal deficit is near historic highs. There’s no crystal ball that lets you see where tax rates might be in five, 10 or 20 years, but paying some tax today might be worth considering—especially if you don’t expect your income to decline in retirement. “For people who have built up solid balances in their investment and retirement accounts, by the time they take all their RMDs from traditional accounts and add in Social Security and other pensions they might be getting, plus take away the deductions they might have had access to when they were running businesses, being in a higher bracket in retirement isn’t all that unlikely,” says Foss.
  • Tax diversification. If all your retirement savings is currently in traditional accounts, shifting some to a Roth account can make it easier to pay for big-ticket expenses without adding to your taxable income. Whether it’s financing a new roof or a multi-generational trip to celebrate a landmark birthday or anniversary, pulling extra money beyond your RMD from a traditional account will increase your taxable income for the year. Pull the money out of a Roth IRA and there’s no tax due (just keep an eye on that five-year rule).
  • No tax headache for heirs. If your intention is to bequeath an account, new rules that went into effect in 2020 require non-spouse beneficiaries to empty an inherited IRA within 10 years. If a non-spouse beneficiary inherits a Roth IRA they still need to withdraw all the money by the end of the 10 year window, but they won’t owe any taxes.

Disadvantages of Roth Conversion

  • You expect your tax rate in retirement to be lower.  If you’re in a high federal tax bracket today and expect your retirement income to be low enough that your tax rate will be lower, too, Roth conversions don’t make any sense. That said, you still face the wildcard issue of what Congress might do with tax rates in coming years.
  • Paying taxes upfront. Do you have the free cash flow to handle the extra tax hit from a Roth conversion? If you have high-rate credit card debt, or your emergency fund is a bit thin, you might want to tackle those issues before giving yourself a bigger tax bill.
  • Social Security issues. If you’re already collecting Social Security, whether the payout is taxable—and the extent to which it will be taxed—is based in part on your income.

The year you do a Roth conversion, your taxable income will rise, which could cause a portion of your Social Security benefit to be taxed or push you into a situation where more of your benefit is taxed.

  • Higher monthly Medicare Part B and Part D premiums. Once you are enrolled in Medicare, the monthly premium you pay for Part B and Part D depends on your modified adjusted gross income (MAGI) from two years ago. If you intend to enroll in Medicare at age 65, that means a Roth conversion when you are 63 might cause your initial Medicare premiums to be more than the standard rates. If your income doesn’t stay elevated, you’ll quickly return to lower rates, though, as your premiums reset every year, based on your taxable income from two years earlier.
  • Less bankruptcy protection. Creditors can’t touch money inside a 401(k) account, but there is a limit on protection of IRA assets. The combined IRA amount protected from creditors in 2021 is $1,362,800. This cap is reset every three years to adjust for inflation—the next adjustment will be in April 2022.

Is a Roth Conversion Right for You?

A Roth conversion can be a smart way to manage your tax bill in retirement if you currently have a large chunk of your savings in traditional retirement accounts. It can also help potential heirs manage theirs.

But given that money you convert is reported as taxable income, it requires a careful approach that doesn’t trigger a huge tax bill in any single year. It can be smart to consult with a trusted tax pro or financial advisor who can help you navigate all the moving pieces of a Roth conversion.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


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